Lawrence LauProfessor of Economics, the Chinese University of Hong Kong

Whither China-U.S. Economic Relations?

July 31 , 2017

The first China-U.S. Comprehensive Economic Dialogue concluded in Washington, D.C. on 19 July without an agreement. There was no joint communique. Even the scheduled separate press conferences were cancelled, first by the U.S., and then by China. What does this mean for China-U.S. economic relations in the future?

First of all, it is useful to note that such an outcome is not totally unexpected. For domestic political reasons, neither China nor the U.S. can appear to make significant concessions at this time. On the Chinese side, the critical Nineteenth Party Congress of the Chinese Communist Party will be held within the next three months and it is important for China to project confidence and strength. On the U.S. side, President Donald Trump has not had much luck in fulfilling his campaign promises, such as the repeal of President Barack Obama's Affordable Care Act, the building of a wall along the entire Mexican border, and the re-negotiation of the North American Free Trade Agreement. The North Korean problem continues to look intractable. And there is the ongoing investigation of the Russian connection. Other proposals, such as the tax cut and the re-building of infrastructure, have not advanced. The President needs a clear and publicly visible win, not a compromise, on this one! He is a deal-maker, a transactional person, and not an alliance or community builder. Tactically, to bluff and threaten first is consistent with his customary negotiation style. He will come back to the deal if it is advantageous.

The principles announced by both sides are unexceptionable. The U.S. side spoke of balance, fairness, and reciprocity. The Chinese side emphasised that the negotiations should be non-confrontational, mutually respectful and produce mutually beneficial outcomes. But neither China nor the U.S. are accustomed to treating another country as a friendly equal. China, which was the dominant power in Asia for many centuries and considered all neighbouring countries as its vassal states until 1840, and then became semi-colonised by the Western powers until the establishment of the People's Republic in 1949, never treated or was treated by any other country as an equal. The U.S., which saved the U.K. and France in the two world wars and occupied Germany and Japan, does not see any of its allies as an equal either. This makes negotiations between China and the U.S. more difficult because the usual proven approaches that work with the other countries do not necessarily work in this case.

Some of the U.S. demands at the Dialogue were actually not supported by even U.S. businesses. For example, the lowering of automobile tariffs in China is not welcome by General Motors or Ford, which has large automobile manufacturing operations in China and benefits from the existing tariffs. The U.S. threatened to impose quota or tariff on imports of Chinese steel and aluminum. But such Chinese imports account for only very small percentages of total U.S. imports of steel and aluminum and will do very little to narrowing the U.S.-China trade deficit. So any such action is merely symbolic. There is also some possibility that the U.S. may label China a currency manipulator so that it can undertake additional protectionist measures against China. However, for the past year, if there were any manipulation on the part of China at all, it was to prevent the Yuan from devaluing against the US$, exactly the opposite to what it should do to gain an advantage for its exports. Moreover, one can also argue that through its quantitative easing policies, the U.S. was actually an indirect currency manipulator.

The U.S.-China bilateral trade deficit is actually not as large as it appears. A recent study that looks at domestic value-added, that is, the GDP created by exports of goods and services to each other in the respective countries, has come up with an estimate for 2015 of a U.S. deficit of US$132.7 billion, compared to an estimate of US$367.4 billion based on U.S. data on exports of goods alone. Moreover, this value-added estimate does not include the value of patent licensing fees paid by Chinese enterprises to foreign (e.g., Irish) subsidiaries of U.S. companies such as Apple and Qualcomm, which can amount to many tens of billions, and which should properly be attributed as the revenue from U.S. exports of services to China. If included, it would make the U.S.-China trade deficit even smaller. Furthermore, it should be recognised that reducing the bilateral U.S.-China trade deficit is not the same as reducing the overall U.S. trade deficit with the rest of the world. It is the latter that matters, in terms of helping U.S. workers through increasing employment and wage rates. If as imports from China fall, they are simply replaced by imports from other countries, U.S. workers will not benefit in any way.

In reality, reducing the U.S.-China bilateral trade deficit by reducing bilateral trade (that is, both Chinese exports to the U.S. and U.S. exports to China) is not in the interests of U.S. workers and consumers. Let us consider an extreme case, suppose bilateral trade ceases altogether, so that there is a trade balance, at zero. This means exports to each other fall in both countries, leading to the loss of a significant number of jobs in both countries, and their rates of inflation will rise, making goods much more expensive to their consumers. Both countries will lose. The efforts of the Dialogue should therefore be focused on increasing U.S. exports of both goods and services to China, which can narrow the bilateral trade deficit and be win-win for both countries at the same time. For example, based on its existing domestic demand, China can import from the U.S. large quantities of oil and gas, now that U.S. restrictions on such exports have been relaxed. It can increase imports of high-technology products, if the export restrictions can be loosened. It can increase imports of agricultural products such as beef, pork, rice and dairy products, in addition to the already huge existing imports of corn and soy bean. The number of Chinese tourists visiting the U.S. will continue to rise, especially now that Chinese citizens are given ten-year multiple-entry visas. The number of Chinese students studying in the U.S. will also rise rapidly. Chinese restrictions on wholly foreign-owned commercial banks and life insurance companies are likely to be relaxed so long as they are reciprocal and that the financial institutions satisfy threshold capital requirements and operate with domestically capitalized subsidiaries. With a coordinated effort, the U.S.-China bilateral trade deficit can be significantly narrowed, if not closed altogether, within a few years.

A relevant factor for the bilateral investment relations between the two countries is the excess savings in China. Chinese national savings exceed 40% of GDP each year and, given the existing excess capacities in almost all major manufacturing industries, cannot be productively deployed domestically. Thus, these excess savings will need to be invested overseas. The U.S. will be one of the natural destinations. There is therefore the necessity and urgency for a China-U.S. bilateral investment treaty. The Chinese savings can also be invested in U.S. infrastructure projects, either directly, or in their bonds, helping to realise one of President Donald Trump's campaign promises. While some people may fret about the possible impact on national security for foreigners to own U.S. infrastructure, the fact is that the infrastructure is located in the U.S. and the government can always intervene if and when national security is threatened.

In conclusion, there is little doubt that closer China-U.S. economic cooperation is a positive-sum game—both countries can win. The economic recoveries taking place in both countries should help to increase confidence on both sides and the probability of an eventual agreement. Chinese economic growth has now stabilised at an average annual rate of between 6% and 7%, between two and three times higher than that of the U.S. Thus, in the foreseeable future, the rate of growth of Chinese demand for U.S. exports of goods and services is likely to be much higher than that of U.S. demand for Chinese goods and services, so that the U.S.-China trade deficit should be further narrowed. However, an all-out trade war will be damaging for both. I believe rationality, and more importantly self-interest, will prevail and prevent a serious trade war from occurring.

(A slightly shortened version of this paper appeared in South China Morning Post, Hong Kong, 25 July 2017.)